When you're opening a brokerage account, you'll need to decide between a margin account vs. cash account. This can be challenging if you're unfamiliar with how these types of accounts work.
You shouldn't just pick one at random, though, because your selection makes a big difference in your options as an investor. To help you choose the best type of account for your needs, here's everything you need to know about investing with a margin account vs. cash account.
The simplest way to explain the difference between a margin account vs. cash account is this:
A margin account lets you borrow from your broker. A cash account doesn't.
With a margin account, you can make investments on margin. That means you don't need to pay the full cost of the investment upfront, as your broker covers part of that for you.
If you have a cash account, you can only make investments that you pay for upfront using the money you have in your account.
It may seem like a cash account is the way to go if you never intend on investing with margin loans. However, there are other situations where a margin account and margin trading can come in handy. By knowing more about how each type of account works, you can make a more informed decision on choosing a margin account vs. cash account.
Cash brokerage accounts get their name because all trades have to be done with funds that are available at the time of the transaction. Want to buy a stock? You'll need to pay for it in time for the trade to settle. Many brokers go a step further and require that you have the cash in your account when you execute the trade.
When you sell stock, you must wait until the trade settles before the cash is available to you. This typically takes two business days. Until the trade settles, you can't withdraw the money from your brokerage account or use it to buy another stock.
There are certain more complex investment strategies that aren't available to you when you have a cash account.
Futures trading requires the use of margin, so you typically can't trade futures in a cash account. Options trading is available, but it's more difficult to write options contracts. To write options, your positions would need to be covered with shares of the stock in question or enough cash to cover your obligations if the options are exercised. These situations are where the choice between a margin account vs. cash account can be very important.
If you open a margin account, you can borrow from your broker to invest. You're probably wondering how exactly this works.
In most cases, a margin account allows you to borrow up to 50% of the purchase price for investments. This essentially doubles your buying power. Imagine that you have $5,000 cash in your brokerage account and you want to buy a stock priced at $100 per share. With a cash account, you could buy up to 50 shares. A margin account may allow you to buy up to 100 shares worth $10,000, meaning you'd owe the broker $5,000.
Since the broker is loaning you money, it will charge you interest on the amount you borrow. It will also use the value of your stocks and other investments as collateral.
There are many situations in which margin can be helpful, such as investments in futures contracts and complex options strategies where there's a risk of losing more than the initial investment generally require a margin account. If you want to buy a stock immediately but can't get cash into your account for a few days, then a margin account makes what amounts to a short-term margin loan possible. Similarly, if you need to withdraw cash from your brokerage account but don't have enough in the fund currently, then you can use a short-term margin loan only if you have a margin account.
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It's obvious when you compare a margin account vs. cash account that the former gives you more investing options as a trader. At the same time, it also includes additional risks.
Investing on margin has the potential for greater profits or losses. In the event your losses grow too large, your broker could take action to protect the account from losses. Let's go back to that scenario above where you make a $10,000 investment, with half of that being on margin. Then, the stock plunges from $100 to $50 per share.
The value of your investment is now worth $5,000, which is also the amount of your margin loan. Here's what will happen next:
For most investors, the smartest option is to get a margin account with one of the top online brokers and be careful with the margin loan features.
The big advantage of a margin account vs. cash account for a trader is flexibility. If you want to make a trade but you're waiting on a cash transfer that will take a couple days, you can buy the stock right away. You'll also have futures trading and other more advanced investing options available when you're ready for them.
The key is controlling the amount of leverage you use. As long as you don't risk too much, margin can be a valuable tool.
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